If you’re thinking of getting started with investments in the stock market, a mutual fund is an excellent place to start. Mutual funds make it easy to invest in a wide variety of securities and markets in one purchase without being an expert in those areas.
Over the years, mutual funds have grown to be a standard investment vehicle for many investors. There are over 7,600 mutual funds available in the U.S., being managed by expert portfolio managers across various fund companies. So what does this mean for you? First, it gives potential investors many choices when searching for funds to meet your investment objectives. But where do you begin?
Read this guide to learn how mutual funds work, the different types of mutual funds you should know about, their pros and cons, and how you can use this financial scheme as part of your investment strategy to grow your short-term and long-term returns.
What are mutual funds?
Many people begin their investing journey with mutual funds. Mutual funds are a type of professionally-managed investment. They are part of a broader category of investments called collective investment schemes.
Mutual funds pool money from many investors and use the money to purchase securities. The securities held in the fund are pooled into a single fund. The pooling of money allows the mutual fund to purchase securities that are too small in value or number to benefit individual investors.
In return, investors receive mutual fund shares, which convey proportional ownership in the underlying securities held by the fund.
The nature of a mutual fund and how it operates can differ based on when investors can buy and sell shares and the sales volume. Mutual funds are divided into open-end funds and closed-end funds.
Open-end funds
Open-end funds are open to investors buying and selling shares at any time. In addition, there is no limit to the number of investors in the fund. Most mutual funds fit into this more flexible and liquid category, but it’s also worth mentioning that open-end funds tend to have higher volatility.
The net asset value (NAV) can be subject to more fluctuations as open-end funds buy and sell fund shares.
Closed-end funds
Closed-end funds are the opposite. These funds have an initial public offering (IPO) where they offer a limited number of shares to investors only once. It’s pretty similar to how companies raise money during their IPOs.
Closed-ends funds are lesser in volume than their counterpart. They’re not as popular due to their more exclusive nature and less flexibility overall. Growth in such funds depends not on new investments made but on the returns earned from the funds received during the IPO.
Types of mutual funds
As you get started with mutual fund investing and pouring through a fund’s prospectus, you might get overwhelmed with the different types and options you have available to you. Here are the most common terms you might stumble upon and those you should know from day one.
Passive funds
A passive fund involves investments in asset classes and specific securities aligned toward a common benchmark. They often try to match the performance of a market index.
Passive funds don’t require financial advisors at the helm and thus, feed into lower management and fund fees. Passive funds have grown in popularity due to these lower overheads and their more ‘hands-on’ approach.
When you think of passive funds, there are two to know.
Exchange-Traded Funds (ETFs)
An exchange-traded fund (ETF) is a stock that can be bought and sold during market hours. This can make it a good choice for both do-it-yourself investors and investors looking for ways to get involved in the stock market without actually buying shares.
ETFs have become a popular investment mechanism because of their flexibility and low cost. They trade whenever they are open, unlike mutual funds or stocks. They also don’t require a broker, as you can trade them entirely online.
Some popular examples include:
- BNY Mellon US Large Cap Core Equity ETF (BKLC)
- JP Morgan Betabuilders U.S. Equity ETF (BBUS)
- SoFi Select 500 ETF
Index Funds
Index funds constitute stocks and bonds already listed on a well-known index. The risk associated with these funds thus mirrors the risk of the index in question. So, for example, if you’re investing in the S&P 500 index fund and the S&P 500 drops by 8%, then it’s safe to assume your index fund valuation dropped by that much too.
Because the fund sticks to an established index, there will be fewer expenses involving research from investment advisers or analysts. These funds are usually meant for risk-averse investors who want to stick to market norms.
Some popular examples include:
- Fidelity 500 Index Fund (FXAIX)
- Schwab S&P 500 Index Fund (SWPPX)
- Vanguard 500 Index Fund – Admiral Shares (VFIAX)
Active funds
A fund’s main investing goal is to generate returns that beat its benchmark index. This can be done by actively selecting stocks that are expected to outperform the market or simply by taking advantage of the inefficiencies and nuances of the market. This is the principle by which active funds work.
Contrary to passive funds, active funds employ a professional manager or team at the helm who collectively decide how to spend the fund’s money and boost the returns. This involves financial experts and investment advisers who have a great deal of technical knowledge on the market and trading.
Thus, actively managed funds carry higher admin and management fees for their fund’s investors due to the ‘hired help’ for the investment style.
Equity Funds (Stock funds)
The largest and most prominent types of active funds are equity funds, also known as stock funds. As the name implies, equity funds invest primarily in stocks. They can be sub-divided on many bases, including the type of company the funds invest in (small, mid, or large-cap) and the investment approach (aggressive growth funds versus income-oriented funds).
Managed well, equity funds can provide incredibly high returns, but they are not without risk. Several high equity profile funds have either gone out of business or merged into other companies due to losses sustained during economic downturns.
These downturns in the equity markets were felt across the board, affecting both small and large companies and domestic and international stocks. However, some funds managed to produce gains during these times thanks to their managers’ ability to select stocks that continued to increase in value despite market conditions.
Some popular examples include:
- Fidelity Advisor Series Growth Opportunities Fund (FAOFX)
- American Century Focused Dynamic Gr Inv (ACFOX)
- Touchstone Sands Capital Select Growth Y (CFSIX)
Fixed income funds (Bond funds)
Next, we have fixed income funds. Fixed-income mutual funds pay a determined rate of return and are more ‘secure’ in this sense. The fund portfolio is structured to build interest income passed onto the shareholders.
They buy undervalued bonds and then aim to sell them at a profit. So you might see higher rates of return with fixed-income funds than debt market instruments and money market funds. But again, this is subject to the fixed income/bond instruments invested.
Keep in mind that fixed-income funds are also subject to interest rate risk.
Some popular examples include:
- T. Rowe Price Instl Lng Dur Crdt Fund (RPLCX)
- PIMCO Long-Term Credit Bond Fund (PTCIX)
- SEI Long Duration (SIIT) Fund (LDRAX)
Income funds
An income fund is a mutual fund that focuses on current income. The income is focused periodically, either monthly or quarterly. Income funds often include a mix of government and corporate debt obligations, dividend-paying stocks, and preferred stocks.
An income fund intends to provide a steady flow of current income rather than appreciating capital gains. This requires investing in lower-yield securities such as bonds that may fluctuate in value and carry a higher risk of default or price depreciation. An income fund does not try to maximize capital appreciation or attempt to capitalize on short-term price changes in a market sector or stock market index.
Although an income fund may participate in some growth investing and bond arbitrage, it is primarily concerned with generating current income by choosing investments that have a history of providing stable cash flows. Hence, they are considered lower risk.
Some popular examples include:
- T. Rowe Price Equity Income Fund
- Fidelity Strategic Income Fund (FADMX)
- Invesco Rochester Municipal Opportunities Fund (ORNAX)
Balanced funds (Asset Allocation funds)
Balanced funds invest in both stocks and bonds. The name comes from the fact that these funds seek to balance riskier investments, such as stocks, with more conservative ones, such as bonds.
Investors should choose a balanced fund based on their risk tolerance and investment objectives. Generally, balanced funds are suitable for investors looking for diversity in their portfolios but not necessarily seeking high returns in any particular category.
Truly balanced funds invest in both stocks and bonds. Some balanced funds also include money market instruments and cash. Others hold mostly stocks but also some bonds and liquid instruments.
It is worth noticing that a balanced fund is not necessarily a diversified fund. It depends on your own asset allocation goals.
Target date funds also fall under asset allocation funds. Such funds target a specific date, usually linked to a milestone event like retirement, for instance. They have a targeted mix of asset classes that initially pose a higher risk-return position and, over time, decrease in risk as the fund gets closer to the target date.
Some popular examples of balanced funds include:
- iShares Core Aggressive Allocation ETF (AOA)
- iShares Core Conservative Allocation ETF (AOK)
- Vanguard Balanced Index (VBIAX)
Money market
A money market fund is a mutual fund or ETF that invests in short-term debt instruments that are highly liquid. These include cash and liquid instruments like certificates of deposit and commercial papers, debt-based securities with short-term maturity, and high credit ratings. They tend to be ultra-safe but pay low-interest rates due to their risk-averse nature.
Money market funds are often considered cash equivalents, though they technically aren’t cash, simply due to their highly liquid form. They are generally not subject to significant credit risk because they are usually obligations of the U.S. government or its agencies or high-grade commercial paper. The issuers are large corporations with well-established financial conditions.
Money market funds provide investors with a safe and convenient way to earn a return on their money while remaining flexible enough to meet day-to-day spending needs.
Some popular examples include:
- Vanguard Treasury Money Market Fund (VUSXX)
- Schwab Value Advantage Money Fund (SNAXX)
- Fidelity Investments Money Market Portfolio (FMPXX)
High yield funds
High yield funds include investing in funds that are constituted of corporate bonds that are rated below investment grade by numerous ratings agencies. This means they often have a B.A., B.B., or lower rating, classing them in the “junk” bonds section.
Junk bonds pay more interest than other bonds. However, they also have additional risks. For example, if the company goes bankrupt, high-yield bondholders get only pennies on the dollar. But in return for added risk, you get a higher yield, anywhere from 1% to 3% or more in interest every year.
These are extremely risky investments and should only be purchased by investors with a high-risk tolerance. If the company becomes financially unstable, the bond may not be paid back at maturity. Keep in mind that the higher the rating you purchase, the less risk you incur.
Some popular examples include:
- Federated Hermes High-Yield Strat Port (FHYSX)
- RBC BlueBay High Yield Bond Fund (RHYAX)
- PIA High Yield (MACS) Fund (PIAMX)
Specialty funds
Specialty funds have proven to be popular but don’t necessarily belong to the more defined categories described so far. These types of mutual funds don’t focus on diversification. Instead, they choose to zero in on specific sectors of the economy or targeted strategies.
Specialty funds can be anything from those that focus on investing in companies in Asia to those that target companies involved with biotechnology. Some specialty funds are also sector-specific. Sector-specific funds invest only in companies associated with one industry, such as energy or banking.
These funds aren’t necessarily more risky than other mutual funds, but they’re not right for everyone. Instead, they’re most appropriate for investors who have specific knowledge about or experience with the sector the fund invests in and want to add it to their portfolio.
Sector-specific mutual funds may also be appropriate for investors who want to use mutual funds as part of an overall investment strategy but have no interest in learning about individual companies. Instead, they prefer to have someone else make all the investment decisions for them.
Some popular examples include:
- T. Rowe Price Communications & Tech Fd (PRMTX)
- Fidelity Natural Resources Fund (FNARX)
- Rydex Consumer Products Fund (RYPDX)
International funds
International funds are exactly how they sound. They invest in assets outside your home country, often in currencies other than your own. An international or foreign fund will generally invest in stocks or government bonds of other countries, such as the United Kingdom or Japan.
In an international fund (or foreign fund), you will find investments from all over the world: Canadian bonds and Norwegian stocks and Mexican mortgages, and Brazilian soybeans, for example.
A global fund invests in any kind of asset, regardless of where it is located: U.S.-traded stocks, Japanese real estate, German bonds, and so forth. A global fund might own shares in an Australian bank, Mexican oil wells, and a French insurance company, so its performance will depend on how well companies worldwide do.
An international fund’s allocations can vary considerably from one fund to another; some might have larger allocations to emerging markets or smaller allocations to a large value. Their performance also can be affected by the financial markets and conditions in those markets, resulting in declines if their domestic conditions change.
This exposure can enhance diversification for investors interested in broad international investments but unable or unwilling to buy individual international company stocks or overseas mutual funds.
Some popular examples include:
- Goldman Sachs International Eq ESG Fd (GSIFX)
- Oberweis Emerging Markets Fund (OIEMX)
- Morgan Stanley Europe Opportunity Fund (EUGAX)
Mutual fund fees
Mutual funds fees can vary in numerous ways. Some mutual funds provide their investors with different fees, which are all deducted from the fund’s assets. The most common fees that exist today include sales charges, sales loads, redemption fees, management fees, and account service fees.
- Sales charge is a fee charged by the mutual fund when you buy shares in it. It is paid to the advisor or the broker-dealer, representing the purchase of fund shares. The load can be front-end (at time of purchase), back-end (at the time of selling shares), or level (as long as you own the investment).
- **Sales load **is a commission levied by the selling broker when shares are purchased through them. A percentage of your investment goes directly to the broker who sold you the shares in the fund. This fee is usually called a “load,” although some mutual funds don’t use an actual commission but instead charge a 1 percent annual fee for the first year.
- Redemption fee is a charge for selling shares within a period of time specified by the company or mutual fund, usually within seven days after the purchase date.
- Management fees are charged to cover the expense of professional fund managers who help you get the best returns from the fund.
- Account service fee is levied on those accounts that do not meet minimum required balance levels or fail to maintain a specific account activity level.
How do mutual funds make you money?
Investing in a mutual fund or any type of financial security or instrument brings about returns in the form of investment returns. For example, even with the money you put in a savings account, you gain interest income for cash that otherwise would have just been lying around at home. Likewise, mutual funds can boost the value of your investments.
There are mainly three ways your total returns will grow through investments in a mutual fund.
- Dividend payments
Sometimes, the securities you invest within your portfolio will earn dividends. This gets split among all investors as direct dividend income or reinvesting the returns into the fund.
- Capital gains
A fund may sell a security that has gone up in value to profit from the cost price that it was initially purchased. This is referred to as a capital gain. The opposite refers to a capital loss. After offsetting capital gains and losses against each other, the net capital gain is often distributed to the mutual fund’s investors annually.
- Net asset value
The net asset value (NAV) refers to each mutual fund share price. It is calculated by dividing the total financial worth of the fund by the number of all the shares. The more a fund’s value grows, the more the NAV will increase. Should you decide to sell your mutual fund shares, you can profit if the NAV is greater than when you first bought into the fund.
Risks of mutual funds
Mutual funds can be an excellent way for people with limited resources to spread out their investments, but they also carry some risk.
Like all financial investments, mutual funds also have their share of risks. Therefore, it’s important to be aware of the flip sides to know what you’re getting into when you invest in a mutual fund.
No guaranteed return
Mutual funds are often looked at as risky investments because of the possibility that they may lose value. There is no guarantee of the valuation as there is always a possibility that the value will depreciate. You can’t also get insurance to back you up as the FDIC, Federal Deposit Insurance Corporation, does not cover mutual fund investments in its plans.
Predicting what will happen with the stock market is difficult at best. If you try to anticipate how your mutual fund will perform, you are essentially trying to guess what the manager will do in any given year. Unless you have extensive experience in the financial markets, it may not be possible for you to make an accurate prediction. Thus, you’re bound to see fluctuations at some level.
However, mutual funds are still much less risky than stocks because they have a set time limit (typically 5-10 years) and have pre-determined payout sizes, so investors know exactly how much they will earn.
Risk of “diworsification”
The beauty of mutual funds is their simplicity. However, mutual fund investors may tend to overcomplicate their portfolios by acquiring too many funds of the same type without diversifying them. On the contrary, you can also over diversify and have too many eggs in one basket, having the total opposite of a balanced fund.
This is called diworsification, leading to a ‘worse’ portfolio than the one you should have.
Here are some examples of investing in overly complex or concentrated portfolios:
- Investing in too many similar or related securities
- Investing in securities from the same industry
- Over-concentrating a portfolio in a particular geographic area
- Over-concentrating a portfolio in a particular economic sector
The solution to diworsification is simplicity and focus. Investors should focus on one asset class (such as stocks) rather than diversifying across multiple classes (stocks and bonds. You can follow the SEC’s recommendation of having at least 80% of your assets in a related investment.
Fixed time for conversions
While mutual funds benefit from having higher liquidity, you can only convert and redeem your mutual fund shares at the end of each trading day. This is different from stocks, which you can convert at any time of day. You may also have to pay redemption fees.
Fund evaluation can be tricky
If you’re looking to invest independently, avoid the cost of high brokerage and not consult with a mutual fund adviser, you might find that researching funds can be challenging. Instead, stocks are more straightforward, offering metrics like sales growth and earnings per share (EPS) for comparison.
Mutual funds, however, offer NAV as the primary basis of comparison. But funds are varied with different degrees of diversification and investment distributions in different asset and share classes. So directly comparing one fund to another using the NAV won’t do.
Benefits of mutual funds
Mutual funds are a great place to start for beginners in investing. Here’s how you can benefit from getting started with a mutual fund.
Diversify your investments
There are mutual funds available for a wide range of investment strategies, so you can diversify your portfolio even if you only have a small amount of money to invest.
Mutual funds are available for nearly every type of investment strategy. For example, you can buy domestic stock funds, diversify by buying world stock funds that include stocks from around the globe, or buy sector funds that focus on a particular industry such as energy or technology. If you prefer bonds, bond funds focus on different maturity ranges or interest rates. There are even funds that combine stocks and bonds in one package.
By investing in several securities, even if several of them lose their value, you still profit because the others offset those losses.
Lower costs
Depending on the kind of mutual fund you opt for (i.e., passive or active funds), the costs may differ, but mutual funds still record lower costs compared to other financial instruments. They often have lower commissions and fees than buying individual stocks through a broker or other financial professional.
Mutual funds also benefit from economies of scale. For example, when you try to create your portfolio of stocks outside of a mutual fund, there are significant transaction fees you’ll incur during the purchase of every individual security. Instead, you can invest in a fund and get access to a diversified portfolio of multiple stocks at one go, at much lower fees.
Assistance from your investment manager
Mutual funds allow you to benefit from the work of a professional investor without having to do it yourself. They are likely to determine better when to sell one stock and buy another than most individual investors.
To beat the market may not be a realistic goal for most individual investors. While market timing doesn’t always work well, attempting it can be perilous. A mutual fund manager can develop a strategy similar to market timing but has the added benefit of diversifying your portfolio among many different companies instead of simply switching from one company’s stock to another.
Simple to invest in
Some people prefer to avoid getting involved with individual stock investments, especially beginners. You wouldn’t want the hassle of having to pick one or risk losing money by choosing the wrong one. It’s also easy to invest in mutual funds.
With a few clicks of your computer mouse, you can purchase and sell shares through an online broker. The broker will handle the paperwork and provide regular reports showing how your mutual fund investments are doing. This eliminates the need to write and mail dividend checks to yourself and the wait between ordering and receiving dividend checks from individual stocks.
Recommended fund managers
When investing in a mutual fund, it’s essential that you consider the fund managers involved. The fund managers play an integral role in managing the portfolio of the stocks and bonds and any other asset class, even if managed passively. Their role can make or break your investment.
The best fund managers will have experience managing portfolios and have high levels of education/training. They should have solid track records concerning their performance, and they should be able to explain their strategies in ways that make sense to you. Ideally, they’ll be willing to answer your questions about their techniques and how they use them to manage your investments.
If a firm has a large number of managers, you’ll want to choose one who works closely with a team of analysts who can help identify good stocks that fit into their investment thesis.
Additionally, you should look into these questions:
- Investment philosophy/process – Is the fund manager simply buying good stocks and holding them, or do they have an investment philosophy? Does the philosophy align with yours?
- Proven investment strategy – Does the fund manager have a performance track record that can be measured? Their track record should show their ability to generate returns for investors over time, including those from major connections and markets.
- **Risk profile **– What is the risk profile of their portfolio compared to others?
- **Management style **– How do they react to market fluctuations? What is their management style?
- Ability to anticipate change – To accurately predict change, it is essential to understand what’s going on right now and how things will develop in the future. The fund manager must take into account macroeconomic and external factors.
Some resources and managers to check out include:
- FINRA: A not-for-profit organization that works under the SEC to provide safe and essential tools for investors to make guided decisions.
- SIPC: Another non-profit but non-government membership-based corporation protecting customer assets and financial interests.
- **Fidelity: **An investment company that can help you manage your investments through brokerage accounts and help you choose the suitable mutual funds for you.
- Morningstar: A private company that provides independent data and research insights, ratings, and tools to help guide investment decisions.
- **Vanguard: **A large investment company that offers a variety of low-cost mutual funds you can choose from, including their advisory team.
- Merril Lynch: An investment management company that houses expert financial advisors and a variety of their funds to help you grow your income.
How to get started
There are some key points to keep in mind as you get started with your mutual fund journey.
Determine your investment goals and time frame
It’s important to remember there is no such thing as a perfect mutual fund, but with the proper research and approach, you can find one that meets your needs.
Read the prospectus of the mutual fund you’re thinking of getting started with as well. The prospectus is a detailed document that mentions the fund’s risk profile, past performance history, professional management, and fees.
Remember, the longer you invest in a mutual fund, the higher the risk. But with higher risk also comes the chance of higher returns.
Consider your asset allocation
Be clear about your asset allocation goals.
Do you want a mixture of stocks? If so, opt for balanced funds. A balanced fund invests in both stocks and bonds. Because it’s diversified, you’re protected if the stock market tanks. Some balanced funds include domestic stocks and bonds, while others have international stocks.
You can also try target-date funds, which are mutual funds designed to help investors reach specific financial goals. For example, some may be focused on IRAs (individual retirement accounts) and building them in line with their retirement plans or taking some time off work after having children. Target date funds alter their investments over time depending on the end goal.
Don’t go into investing assuming that you’ll beat the market or that your stock picks will make you rich overnight. Any money you put into mutual funds should be money you can afford to leave there for years, especially if you’re in it for high returns.
Budget your investment costs
Mutual funds are not appropriate for everyone.
If you have short-term investing needs or a limited appetite for risk, you’re probably better off putting your money in a bank savings account or buying a bond fund than you would be investing in stocks via mutual funds.
Some people prefer to invest in individual securities rather than through an investment company that combines the holdings into one package. Investors who use this strategy often say they are trying to avoid paying “expense ratios” — that is, they want to pay only once for professional management.
Choose the right fund depending on your budget and financial plan.
FAQs
Should I invest in mutual funds?
Mutual funds are a great place to start on your investing journey. Mutual funds are considered a safer investment strategy than acquiring individual stocks as they offer diversification benefits.
Are mutual funds safe?
Mutual funds carry a degree of risk as they fluctuate in value over time. The level of risk can vary depending on the nature of your fund and the mix of assets you’ve invested.
Can you get rich with mutual funds?
Yes, with time and strategic investments. Mutual funds have high returns for long-term investors who learn to navigate the funds smartly.